The number one reason that stops many people from pursuing forex trading as a career or side hustle is the risk that comes with it. Everyone knows about the enormous amount of trading opportunities and lucrative nature of the global currency market, but they are still hesitant to enter the forex world because of the fear of losing money. But there is a saying that you must be willing to lose something to gain something greater, and those brave enough to take the risk with a solid plan will surely be rewarded in the end. In this article, you will learn about all the risks in forex trading and the top 5 pro tips you can follow for risk management. So, let’s get started without any delay.
Forex risk – Basics
Before learning about risk management, you need to understand the risk in forex trading and where it comes from. When we engage in trading currencies, we analyse the market situation to predict the potential price movements in the chosen currency pair and take a trade position based on that. If we anticipate the price to move up, we will place an order to buy the pair and sell it later for a higher price to make a profit. If we expect a price drop, we will open a sell position to gain from the falling prices later. But our calculations are merely based on possibilities, and they can go wrong due to the unpredictable nature of the forex market. Thus, the trade we entered, expecting to earn some profit, can result in losses.
The potential losses we have to bear when the market becomes unfavourable and prices move in the opposite direction of what we had forecasted is the risk of loss in forex trading. We can never expect to win every single trade we enter, and hence, the key to success in forex trading is minimising the losses that happen and maximising the profits whenever the market is in our favour. This is done with a solid strategy, using multiple trading tools and a sound risk management plan, three of the most essential components that make your trading system work in the best possible manner.
Types of Risks in Forex Trading
- Volatility Risk
The primary risk in forex trading is the volatility risk. The trading instruments in the forex market are international currencies that are paired and quoted against one another. The prices of these currency pairs are exchange rates between currencies that constantly fluctuate due to the changes in market sentiments as well as complex economic and geo-political factors. The frequent price movements are explained with the term volatility, allowing us to profit from the favourable fluctuations. But like I said before, price movements can also be unfavourable for a trader at times, and in this case, the volatile nature makes forex trading risky for everyone.
Traders are trying to deal with the volatility by relying on technical and fundamental analysis, but no one can make a 100% accurate prediction of the upcoming market scenario. Pip is the standard measurement unit that we depend on for calculating the price movements, and the value of one pip is just 0.0001 for all pairs except the ones with Japanese Yen, where it becomes 0.01. The pip value is different for different currency pairs, and the monetary value of pips depends on the base currency we have chosen for funding our trading account.
Understanding the concept of pips is crucial to calculating the profits and losses in forex trading, as it is easy to convert the gains and losses when you can measure them in pips. It would be hard to keep track of it due to the extreme volatility that we experience in trading, and hence, brokers have added beginner-friendly tools like pip calculators, which allow traders to make complex calculations easy.
- Interest Rate Risk
One thing that differentiates the forex market from other financial markets is the strong impact and influence of interest rate decisions. The currencies that we trade with are regulated and controlled by the Central Banks of the countries that they belong to, and they will often make decisions about changes in interest rates as a method to deal with economy-specific financial conditions. To cite an example, you will hear about the Federal Reserve planning for rate hikes when the US inflation is elevated, and they will pause or slow down the rate hike once the inflation comes under control.
Such decisions will impact the prices of all major pairs, which is what happens with all currency pairs when the Central Bank decides about interest rates. The interest rate proposed by the Central Bank of a country is an indicator of the financial condition of that economy, and it tells us about the currency’s strength or weakness as well. Not to forget the application of swap rates on overnight trade positions, which is the interest rate differential between the 2 currencies in the pair that we trade with. Hence, a sudden change in interest rate can invalidate our analysis and calculations, and this is the interest rate risk in forex trading.
- Liquidity Risk
In simple words, liquidity is the ability to convert an asset into ready cash and in the context of forex trading, it is the ease with which one can enter or exit trade positions. When you are able to buy or sell a currency pair at desired prices without any hassle, the market can be referred to as highly liquid. The presence of buyers and sellers is important to ensure enough liquidity while trading. Forex brokers partner up with top-tier financial institutions functioning as liquidity providers to provide solid trading conditions to their clients. Lack of liquidity during volatile hours results in price requotes and slippages, leading to losses, which is referred to as liquidity risk in forex trading.
- Leverage Risk
Leverage is an arrangement with your forex broker by which you can opt for a larger trade size with a relatively smaller amount of trading capital. Trading with leverage amplifies your gains and losses and is more like trading with borrowed money. Your trade size determines your potential profits and losses, and when your calculation goes wrong in a leveraged trade, you will lose more money than you had originally risked for trading. This is the leverage risk in trading.
Top 5 Tips to Manage the Risk
- Setting Stop-loss in Every Trade – The first tip is setting a stop-loss in every trade, which is also an unwritten rule that has to be followed by each and every trader in the forex market. A stop loss that is placed properly is a lifesaver when things go wrong, as you will be out of that trade before the losses eat up all of your trading capital. I suggest using a tool like a Forex profit/loss calculator to determine the estimated profits you want in a trade and then place a stop loss accordingly to limit your losses in an unfavourable market condition.
- Limit Your Leverage – Leverage is surely a powerful tool for traders, but excess leverage can also kill your account, wiping away your entire trading capital. Hence, you must limit leverage and prioritise risk management every time you rely on leverage while trading.
- Don’t Trade When There is Extreme Volatility – You will come across many situations when the market is highly volatile, and there is a sudden increase in trading opportunities. However, this might not be the right time to trade as you will get caught up in the volatility, resulting in losses. You might also encounter slippage and price re-quotes if insufficient liquidity can withstand the volatility. Hence, it would be best to wait and let the market calm down a bit before entering a trade.
- Avoid Emotional Trading – Trading should be based on detailed analysis and logical calculations. It would be impossible not to experience any emotion while trading. But you should never let these feelings dictate your trading decisions. Emotional trading often turns into overtrading, which eventually kills your account. So, you need to avoid it at all costs.
- Keep Learning – Even the most experienced traders will have certain things they aren’t good at yet, and you need to keep learning to enhance your trading skills. Theoretical learning and practical experience are important for growing and advancing as a trader.
In the end, risk management is a mandatory practice for all forex traders. You can never be fully free from the risk, but you can cut it down using proper tools and making calculated moves. A risk management plan reduces the losses and optimises your profit potential. I hope you will consider all these points and trade safely from now on.